Feb. 13 (Bloomberg) -- Standard & Poor’s slapped its best
possible grade on 84 percent of a $500 million collateralized
debt obligation named for a thorn tree, 98 percent of which was
subprime residential mortgage-backed securities. The sting came
a year later.

About $420 million of Acacia Option ARM 1 CDO Ltd.,
underwritten by UBS AG, received a credit rating of AAA in May
2007, according to a Justice Department complaint against S&P
and its parent, McGraw-Hill Cos., filed Feb. 4 in federal court
in Los Angeles. A bank unit of Chicago-area First Midwest
Bancorp Inc., a federally insured financial institution, lost
almost all of its $8.8 million investment in the CDO when it
defaulted in May 2008.

Acacia Option is one of dozens of deals listed in the
government’s lawsuit that received S&P’s highest AAA grade. The
U.S. is accusing the world’s largest credit rater of
deliberately misstating the risks of mortgage bonds to keep its
share of the booming business of repackaging home loans for sale
as securities. The lawsuit seeks penalties that may amount to
more than $5 billion, based on losses suffered by federally
insured financial institutions.

S&P was aware of its influence over such firms, and
knowingly “devised, participated in, and executed a scheme to
defraud investors,” according to the complaint.

Ed Sweeney, an S&P spokesman, and Megan Stinson of UBS,
both in New York, declined to comment.

Subprime Collateral

So-called option adjustable-rate mortgages, a type of loan
that allowed borrowers to pay less than the monthly interest due
with the shortfall added to the balance, were among the
“toxic” debt that the Financial Crisis Inquiry Commission said
was at the center of the “corrosion of mortgage-lending
standards” that helped fuel the housing boom and subsequent
bust.

While about 21 percent of the collateral backing the CDO
was subprime RMBS taken out by borrowers with poor credit, S&P
rated about $420 million of the CDO AAA, and about $470 million
A or above. It confirmed these ratings on October 3, 2007. Less
than two weeks later, S&P downgraded almost 14 percent of the
underlying subprime RMBS collateral.

First Midwest Bank, whose Itasca, Illinois-based parent had
a market capitalization of $971 million at the end of 2008, lost
almost all of its $8.8 million investment in an A portion of the
CDO by May 2008 when Acacia Option had defaulted.

‘Very Disappointed’

First Midwest had a net loss of $26.9 million in the last
quarter of 2008, in part from higher impairment charges tied to
investments. Three trust-preferred CDOs, with face value of $39
million, were written down by $25 million, and the company also
cited an unrealized loss of about $18 million on another $46
million of trust-preferred CDOs that were “temporarily
impaired.”

“We are very disappointed in the necessity of these
actions and their impact on our 2008 performance,” Michael
Scudder, chief executive officer, said in a regulatory filing on
Jan. 22, 2009. “However, these are extremely difficult economic
times with consumers and businesses falling under increasing
strain. The severity of the times requires that we address the
problems of the day head on.”

First Midwest lost $193.7 million of cash from investing in
the second quarter of 2008, and $6.4 million and $312 million in
the next two periods, according to data compiled by Bloomberg.
By 2009, the bank had $915.8 million inflows from investing, and
it was able to repay $193 million in Troubled Asset Relief
Program bailout funds to the U.S. Treasury Department, the
department said in November 2011.

Changed Accounting

Redwood delayed filing its 2007 annual report to evaluate
declines in the value of securities it held, after the fourth
quarter’s total negative fair-value adjustments of $956 million,
Redwood said in a statement on Feb. 29, 2008.

At the beginning of 2008, Redwood adopted a new accounting
standard that changed the way it accounted for assets and
liabilities at its Acacia CDO entities.

Demanding Information

The Securities and Exchange Commission demanded information
about its Acacia CDO business in May 2010 on topics including
“trading practices and valuation policies,” Redwood said in an
August 2010 filing with the agency.

CDOs pool assets such as mortgage bonds and package them
into new securities with varying risks in which revenue from the
underlying bonds or loans are used to pay investors.

S&P’s CDO group ignored warnings and data from its mortgage
securities unit that their MBS ratings, used in grading CDOs,
were proving flawed, according to the complaint. The lawsuit
includes at least 58 examples of S&P executives taking steps to
appease issuers or acknowledging how pressure from banks could
lessen the quality of its grades or delay downgrades.

The ratings company contests the suit’s allegations.
Despite its best efforts to “keep up with an unprecedented,
rapidly changing and increasingly volatile environment,” the
severity of “what ultimately occurred” was “greater than we -
- and virtually everyone else -- predicted,” the company said
in a Feb. 4 statement.

S&P said in the statement that all of its CDOs cited by the
Justice Department received the same ratings from a competitor.
Moody’s granted $420 million of Acacia Option ARM 1 CDO the same
AAA as S&P in May 2007.

Acacia is a genus of often-thorny trees and shrubs in the
Fabaceae family, with many species native to Australia and
Africa, according to Encyclopedia Britannica. It’s also a
fraternity founded in 1904, with chapters at colleges including
Cornell University and Pennsylvania State University.

The Justice Department case is U.S. v. McGraw-Hill,
13-00779, U.S. District Court, Central District of California
(Los Angeles).